Using a phrase like “too expensive” would seem to be subjective. But compare median house prices with median income (via Patrick). If people’s incomes aren’t climbing, how can they afford so much more house? (Click on the image to see a larger version of the chart….and the back button to return to the post)

This is a very common argument peddled by housing bears. Home prices have to fall to re-establish their historical relationship with median income. (I’ve made the argument myself on this blog). Then I went back and looked at interest rates:

Maybe I’m missing something here, but it strikes me as obvious that house prices relative to income were lowest in 1982…interest rates were 18%!

With a fixed rate 30-year mortgage of 18%, a $2000 monthly payment will buy $132,000 worth of home. Cut the interest rate to 6% and the same $2000 payment will buy $334,000 worth of home.

In this example, home prices may be higher, but the total cost of the home purchase–using only price and mortgage interest as inputs–is the same.

While I agree overall that house prices have to fall, I’ve become skeptical about conclusions drawn from the first chart above. The fundamental flaw–you probably know where I’m going with this–is that it is based on a home’s price, not the total cost of home ownership.

So an important consideration has to be, where are interest rates headed? If mortgage rates stay around 6%, then objectively-speaking, house prices should remain well above the “historical” relationship with median income since below “average” interest rates would support above “average” prices.

And yet I certainly wouldn’t argue that low interest rates will keep prices from falling farther nationally. In those markets with exploding inventories (the Inland Empires and McHenry Counties and Sarasota) prices are sure to keep falling until inventories have returned to normal.

5 Responses to “Homes are still too expensive, but by how much?”

It seems to be that you overlooked one important point in your analysis, and I could be wrong but …

Inflation adjusted USD from your benchmark 1982 and 2001 we saw a USDX at roughly 120.
(source: http://www.zealllc.com/2008/realusdx.htm)
Since that time the USD has lost some 40% of its purchasing power. Cutting the interest rate to 6% and a home price $334,000, home prices would have to fall in line with 1982 levels of $133K in order to purchase the same value home.
Since the recent RE bubble produced many Mcmansions of emmense square footage and limited property I would guess this may be where the average house value will fall to and what the average house may look like. (peak to trough)

Thanks for the comment Joe. Actually I’m just doing a simple present value calculation, holding payment, future value, and number of payments constant. Then I test two different interest rates to determine present value of the home.

I’m looking at one theoretical house at a particular moment. Inflation is the impact of the dollar losing purchasing power over time. Since we’re only looking at how interest rates effect the house’s value at present, inflation shouldn’t be a factor.

You seem to be assuming that the average home buyer is making $6000. to $8000. a month. Forget the interest, forget the percentages, forget the inflation and indexes. The average person is making much less than $6000. a month (take home , after other monthly expenses)and should be able to afford a home. I might make around $2000. profit in good month yet I purchased a home in 1995 for about $35,000. and a second home in 2001 for about $80,000. Both were paid off quickly by selling off collections of items (I don’t buy anything new). Somewhere between those two numbers is where the price of homes should be and should stay. I have been offering between $40,000 and $65,000 for homes in my area and the asking prices have been falling from the $220,00 to $300,000. range down to the $80,000 to $160,000 range. Some have sold in the $70,000. to $100,000. range , so even if I’m low, I’m closer to the selling price than the original asking price is. Forget trying to make a bundle off your home and just live in it.

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